The rapidly flattening US Treasury yield curve is prompting a lot of questions about the shape of the curve and it being a good predictor of upcoming recession. We have also had a lot of questions about the steepness of the very front end of the US curve between overnight swap spreads and 3 month libor, and whether this steepness is of concern, as it was during the Global Financial Crisis when banks struggled to finance themselves, causing the front end to steepen.
Starting with the latter question which is by far the easiest, this steepness at the front end of the curve is once again a technicality, but in this case it is not one that can predict an upcoming crisis. The steepness is being caused by the huge issuance of debt from the US Treasury: forecasts for 2018 are for around $1.25 trillion of net supply to help finance the deficit. This is double the net supply seen in 2017, and with significantly less support from the Fed’s balance sheet to help absorb it, the Treasury has had to focus much of that fresh issuance at the front end of the yield curve with the issuance of short term bills. The US primary dealers are obliged to take down this supply which in turn has put pressure on short yields and Libor. This technicality is likely to remain in place for some time while the deficit is so high or until such times that the Treasury feels comfortable issuing more longer dated debt. As an aside, this latter point may also have an impact later on the rest of the yield curve.
Back on to the question of the yield curve shape. An inverted yield curve has historically indeed been a good leading indicator for an upcoming recession - typically a year or so after the US yield curve has inverted, the economy has gone into recession, although the timing of this leading indicator does vary by quite some margin, so investors should be wary of using it as their sole guide. From a fixed income perspective this yield curve shape does make sense at the end of the cycle. Typically, rates rise until such a point that their impact on the economy slows it down too much and the central bank goes on hold. The market then judges that over the longer term that rates must once again come down as the economy slows and inflation is no longer a threat, hence longer dated yields are actually lower than the short dated yields. The next step is usually rate cuts as the central bank moves from hold to expansion once again.
All of this is good common sense, but as fixed income managers we are the ones who create the shape of the curves so we cannot rely on the shape to determine our view on the timing of the next recession! We must look at other macro factors. In the interest of keeping our blogs short(ish) I will write about these other factors separately later in the week. Having said that, we do know that once our curves are inverted the clock is indeed ticking until the next recession, and recession - or market conditions similar to recession - can be self-fulfilling once we hit this point.
The reason we are focussing on this now is because the yield curve in the US between the 2 year Note and the 10 year Note is now the flattest it has been since the GFC: as I write it is just 50 basis points.
So will the curve invert? If so, when? And why?
The first question is easy, yes it most likely will. When and why are certainly more subjective, so here we must look at scenarios and judge how likely they are. In doing so we certainly recognise that making economic predictions longer than a calendar year is difficult and involves many variables.
Where we do have confidence is in the outlook for this year. Other indicators that we will write about shortly certainly do not indicate a recession any time soon, so it would make little sense to have an inverted curve in 2018. However by the end of 2018 we will most likely have Fed funds upper bound rates at least at 2.25% and with the Fed’s dot plots being slowly executed, a further 3 hikes in 2019 should at least be priced into the 2 year Note yield, which would potentially give us 2 year notes at 3% as we enter 2019. This is well supported by our economic view too.
All things being normal, the flattening trend should continue, and in the same bear flattening trend. 10 year yields are today already at 3%, so it is quite unlikely that the curve goes to inverted within the next year. Our most likely scenario for year end is 2/10 curve at around 25bp, with 2s at 3.00% and 10s at 3.25%.
However in a year’s time, if the FOMC maintain that their 2020 Dots are still valid (mean Fed Funds rate is 3.375% in 2020) and the market believes that the Fed will actually go ahead with this, then we think it is very possible that the front end yields rise to the point of the 10 year and we have a flat yield curve. The read across from that would be that market participants would start to predict a recession perhaps a year ahead from there.
Whilst hard to predict from today’s economic data which remains robust, it is not illogical that after 10 rate hikes the yield curve flattens completely. It would already be the longest period of uninterrupted growth on record, and full employment will long have been reached. Add to this an absence of inflation which keeps the long end in check, and we probably should have a flat yield curve.
So in summary:
• In the absence of any shocks we see no recession for at least two years
• The Fed will continue to hike through 2018 and 2019.
• In 12 months’ time our base case is a flat yield curve (2 to 10 years) around the 3.25% level, triggering a recessionary forecast for either 2020 or 2021, which could become self-fulfilling, especially as earnings growth will have peaked well before this.